Senior Housing Cap Rates

If you're involved in the senior housing real estate
industry, you’ve likely heard the term ‘cap rate’ more than once. But, what is
a cap rate? And, how does it affect the value of a senior housing property? And
last, what are some senior housing characteristics that can impact the cap rates?

Capitalization Rates (or Cap Rates) are one of the primary metrics used
by investors in evaluating commercial real estate investments. In short, cap
rates measure the relationship between the price (or value) to the expected
annual income (cap rate = income / price). Therefore, given even income at a
property, a lower cap rate indicates an investor is willing to pay more for a
property with a higher cap rate indicating a lower price.

How does this affect value? As in algebra, as long as we
know two variables, we can solve for the third. So, if we know (or can
reasonably estimate) the expected annual income at the property and can derive an
appropriate cap rate from similar market transactions, we can solve for the
expected price, or value (value = income / cap rate). So, the expected price of
a senior housing property can ultimately be derived from both the income and market
expectations of the capital (cap rate).

However, what property characteristics contribute to the variance
in cap rates? Like all investments, an investor requires a higher rate of
return for taking on additional risk. Simply put, with all other things being
equal, cap rates measure the perceived risk in an investment. So, what makes a
senior housing real estate investment more or less risky? One of the major
factors in senior housing risk relates to the acuity level. A lower-acuity
independent living community is not licensed, and does not provide nursing
services, so the risk of improper care (or losing an AL license) is much lower
than a higher-acuity memory care or skilled nursing facility. Although the
income might be higher at a memory care facility, resulting in a higher value
per unit, the overall cap rate will be lower with level income. Accordingly, a
property located in a larger market is deemed to have a larger demand and
employee pool, and is perceived to be a lower risk to a similar property in a
smaller, tertiary market.

There are many characteristics that can impact the perceived
risk and cap rate at a property. In general, qualities that are perceived to
have lower risk include larger markets, stabilized operations, larger property
size (number of units), private pay reimbursement, newer construction,
continuum of care, reputation of operator, and superior building quality.
Alternatively, the risk is perceived to be higher (with higher cap rates) in smaller,
tertiary markets, non-stable operations (lease-up or turnaround), smaller
property size (less units), management transitions, government reimbursement
(Medicare and Medicaid), older construction, and inferior building quality. In
short, properties with the lower risk profile tend to trade for lower cap rates
than similar property types with the higher risk profile.

Although there are many other macro-level influences on the cap rate environment (capital markets, interest rates, supply of equity/debt, etc.), the above attributes are a few of the micro-level attributes. Also, when a property's income stream is inconsistent, an investor may also use a discounted cash flow analysis to calculate the present value of the future income stream (with an appropriate risk-adjusted discount rate). Feel free to send me your questions and thoughts to Scott McCorvie at scott@srgrowth.com, www.srgrowth.com.